If one has been watching global stock markets for the past six months or so, the overwhelming message has been: The world's coming to an end! No it's not! This bipolar view of our future has led to the Risk On/Risk Off trades in financial markets generating a high level of price volatility in the stock market with little positive or negative movement overall. What has been keeping global financial markets in turmoil has been concern over the pace of the economic recovery in developed economies, the uncertainty about the true health of the Chinese economy, and, most importantly, the lack of confidence that Western Europe can solve its sovereign debt problems. All of these are important determinants for economic activity in 2012, but the European challenge posses a significant dilemma because its resolution will determine the fate of one of the world's major currencies – the euro.
This bipolar view of our future has led to the Risk On/Risk Off trades in financial markets generating a high level of price volatility in the stock market with little positive or negative movement overall
The resolution of these issues depends on how governments are going to deal with their massive debts and unfunded liabilities. These unfunded liabilities are becoming a powder keg in societies, as they often represent the only financial support available for aging populations, a phenomenon that is beginning to overwhelm the fabric of society in many countries. In many European countries, these social payments have encouraged citizens to leave the workforce early. Shrinking workforces have been offset through increased immigration that has added new dynamics to the economic challenges – ethnic and cultural clashes. As minorities with radically different cultures have grown to become meaningful percentages of various country populations, their lack of employment skills that limit many to only menial jobs has contributed to a growing disenfranchised segment of the population. Over the past few years, we have witnessed violence fostered by these cultural and social problems and the belief by these disenfranchised people that they are entitled to economic rewards, which they take when riots lead to ransacking of shops.
The structural problems for many of the wealthy western economies are dictating that overall debt balances need to be reduced in the coming years in order for them to begin growing
To maintain the peace, governments have been forced to spend billions in social welfare aid to these disenfranchised minorities while still supporting their basic geriatric welfare systems. This has contributed to the growth in government debt and unfunded liabilities. The map in Exhibit 10 shows the world with circles representing the amount of government debt outstanding for major countries. The size of the circles suggests the world has been on a borrowing binge financed by a handful of countries with better financial positions. The structural problems for many of the wealthy western economies are dictating that overall debt balances need to be reduced in the coming years in order for them to begin growing. Not until they start growing will governments be able to create well-paying jobs that will employ their growing ranks of unemployed who, at the moment, are adding to the government's financial burden.
The slow economic growth in the western economies is a reflection of the problems caused by this heavy debt load. Government debt contributes to reduced consumer spending, higher inflation, lower capital investment and general anxiety. These reactions also contribute to un- and underemployment, which in turn adversely impacts government finances causing economic pain to be constantly recycled.
We were intrigued in reading a column from an Irish economist who discussed a recent paper by Richard Koo, a Japanese economist, who has studied the causes of the recession in Ireland. Like almost all the countries that experienced a recession in 2008-2009, the initial cause was the collapse in the country's housing market and the resulting fallout. The recession came because of fear on the part of the country's citizens after they saw their wealth evaporate with the collapse in housing prices and the explosion in debt used to finance home purchases. As a result, citizens began to recognize that tens of thousands of their neighbors, and possibly even themselves, were broke and would likely never get out of debt. This made them extremely nervous about spending and incurring debt.
The chart in Exhibit 11 shows how spending (or saving) by Ireland's households, its corporate sector excluding its financial institutions and its government has trended since 2002. The household sector was clearly on a spending/borrowing binge that reached a negative 10 percent of Ireland's gross domestic product (GDP) in 2006. On the other hand, the industrial corporate sector experienced cyclical periods when it generated funds and when it reinvested them during the first few years of the period, but as we neared the latter part of the decade, corporate investment ramped up. During this entire period the government was generating positive savings because it was the beneficiary of tax inflows from the healthy economy. When the housing bubble burst and people landed out of work and families went broke, the anxiety about debt and spending caused families to become reluctant to spend and they avoided debt at all costs while ramping up savings. This anxiety-driven change in spending and savings habits became ingrained, much like the spending and saving patterns of those who lived through the Depression who remained thrifty throughout their lives.
When the housing bubble burst and people landed out of work and families went broke, the anxiety about debt and spending caused families to become reluctant to spend and they avoided debt at all costs while ramping up savings
As the chart (Exhibit 11) shows, the combined savings of households (14.26 percent) and the corporate sector (7.29 percent) reached a combined 21.55 percent of GDP in 2009 compared to about a negative 4 percent in 2006. Government has tried to offset this economic contraction by stepping up its spending, which accounted for 16.78 percent of GDP. The net spread is nearly 5 percent, which is a drag on the Irish economy. The problem is that this spending shift can only last for a short while, as the government finds its ability to finance the necessary economic support limited by its worsening financial picture. In the end, Ireland, along with a number of other western economies needs to deleverage its balance sheet. It is this phenomenon that is restricting economic activity, and in turn energy demand.
Martin Wolf, economic columnist for the Financial Times, has written a column about the fragility of the 2012 economic recovery in western economies. One chart accompanying his article showed how the 2012 economic growth forecasts for western economies were reduced steadily throughout 2011 with the lone exception of a December increase for the United States. (See top chart in Exhibit 12.) The most recent forecasts now call for Italy, which was initially projected to have 1 percent GDP growth this year to now be looking at a negative 1 percent. Spain, with an early estimate of greater than 1 percent growth is now expected to shrink by a few tenths of one percent. That forecast is before the latest government estimates of Spain's budget deficit, now projected at 8.2 percent of GDP, up from the prior estimate of 6 percent. With new government spending cuts and increased taxes, Spain's GDP growth will probably be lower than the December estimate.
The 2012 economic growth forecasts for western economies were reduced steadily throughout 2011
Germany that was once looking at 2 percent growth is now projected to grow by only an estimated 0.5 percent. That will be better than France, which is now projected to barely have any growth in 2012. The net result is that the eurozone is now projected to experience negative growth in 2012 in contrast to the earlier estimate of about 1.6 percent growth. This gloomy outlook will continue to pressure countries in the eurozone to embrace austerity measures to attack their high debt levels, but at the same time further crippling their economies and their growth potential.
Mr. Wolf examines the various government strategies that have been tested in recent years to deal with the economic fallout of the recession and financial crisis. He draws on the theories of Hymen Minsky who laid out a hypothesis for financial instability of economies. What Mr. Wolf fails to address is the prevailing view of European governments that treaty agreements, rules and regulations can solve the problem of a lack of cash. This may be the greatest shortcoming in the European solution to its sovereign debt crisis. Mr. Wolf closes his column with the following observation about the eurozone.
"In the eurozone, however, this shift to fiscal austerity is running alongside a still bigger experiment: the construction of a currency union around a structurally mercantilist core among countries with negligible fiscal solidarity, fragile banking systems, inflexible economies and divergent competitiveness. Good luck for 2012. Everybody will need it." If you are in the energy business, you should not be counting on the eurozone to boost global energy demand this year. Rather, you should be hoping that the eurozone doesn't experience a Lehman-like financial crisis causing the euro currency to implode. The eurozone remains the key risk to the global economy and energy prices in 2012.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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